FundsIndia Explains: How are mutual funds taxed? Part I

Please note – With the proposals detailed in the 2018-19 budget, the rules regarding equity fund taxation as explained in this article do not apply any longer. Click here for the updated rules regarding long-term capital gains tax on equity funds.

If there is one detail regarding investment that everyone pays close attention to, it is taxation. Here’s putting down what you need to know about taxes and your funds.

While much of your other income, such as salary or interest income, is taxed at your slab rate, the gains you receive from mutual funds – called capital gains – have separate taxation provisions. They are called capital gains tax. Since taxation is a vast topic, even while considering only mutual funds, we’ll cover it in two parts.

What is MF capital gain?Capital gain is simply the profit on your investment when you sell your mutual fund units. It is the difference between the market value of your mutual fund units at the time of sale and the cost of such units. The gains come in from the appreciation in your fund’s NAV.

Capital gains can be short term or long term, depending on how long you hold the fund units. Holding period is the number of years between when you first bought a unit and sold it. What is considered short-term and long-term holding varies between equity and debt/gold mutual funds.

In this article, we will look at how capital gains tax applies to equity mutual funds and debt funds. In the next one, we shall see how the taxes are calculated when you buy and sell at multiple points.

Tax on equity funds
Taxation rules on equity and equity-oriented funds are fairly simple. A holding period of more than 12 months qualifies as long-term holding; less than that is short term.

Equity-oriented funds have no tax on long-term capital gains; i.e., if you sell your fund after 12 months from the date you bought it, you don’t pay capital gains tax. On short-term holding, the capital gains tax is a flat 15 per cent, no matter which tax bracket you belong to. Securities transaction tax (at 0.001%) will apply on all redemptions of equity schemes. That is about one paisa for every Rs 1000 of redeemed money and hence ignorable.

All dividends from equity funds are exempt from tax, irrespective of when you receive it.

To qualify as an equity-oriented scheme as per tax rules, the fund should have at least 65 per cent of its portfolio in domestic equity shares on an average. By this definition, equity-oriented balanced funds are also tax-free after a one-year holding period, just like equity funds. They are also taxed at 15 per cent for short-term capital gains. Similarly, arbitrage funds and equity savings funds are also treated as equity for tax purposes.

International funds that invest in the stocks of other markets such as the US or Europe, will not be an equity fund as they do not hold domestic stocks to the extent of 65% (as required by tax laws). Equity fund-of-fund schemes do not enjoy the tax benefits of equity funds because they don’t hold stocks; they hold other funds.

Tax on debt funds
Debt funds, as a category, include liquid, ultra short-term, short-term, income accrual, dynamic bond, and gilt funds. It also includes all debt-oriented funds as MIPs and other hybrid non-equity funds. International funds and gold funds also follow the same taxation as debt funds.

For these funds, short-term is a holding period of less than 36 months. Long-term holding is a period more than 36 months. On short-term capital gains, you are taxed at your slab rate. That is, if you’re in the 20% tax bracket, you pay 20% of your capital gains as tax. If you’re in the 10% tax bracket, you pay 10% tax on your capital gain.

On long-term capital gains, your tax is 20% of the gain with cost indexation benefits. Indexation is the method by which your cost is adjusted for inflation. What this does is to effectively reduce your absolute gain, as your cost goes up and thus reduces your taxable profit. (We’ll do a detailed post on indexation soon!)

While equity funds do not suffer tax on dividend, debt funds do! You do not pay this tax – called dividend distribution tax (DDT). The AMC deducts it from your NAV and remits it directly. So you receive dividend net of DDT.

The DDT rate for individuals at present is 28.84% (including surcharge and cess). Do note that as dividends are paid out from your NAV, your NAV falls post such dividend payout or reinvestment. Hence, the capital gains, if any, when you sell your units under this option will seem lower. But the fact remains that you paid tax on the dividend, which is nothing but part of your profit.

Hence, it is important for you to know whether it is suitable for you to opt for dividend option in debt, depending on your tax profile. We will do a separate article on how to optimally use the dividend and growth option.

Who pays the tax?
If you are a resident Indian, the fund house will not deduct any tax (TDS) when you sell your units. You are required to show the income and pay taxes, if any, when you file your returns. If you are a non-resident Indian, while the tax laws remain the same for capital gains, TDS will be deducted, at the applicable rates, when you sell your units.

Remember that any transaction that involves units going out of your holding qualifies as redemption. So if you’re switching units from one scheme to another or from the dividend to growth option (or vice versa), or making a systematic transfer plan or a systematic withdrawal plan, they’re all redemptions.

65 thoughts on “FundsIndia Explains: How are mutual funds taxed? Part I”

Nice, detailed and point wise explanation of tax incidence on MFs. It is more clear that equity / equity MF dividends do not attract any DDT, while Debt MF dividends attract 28.84% DDT in case of individuals – which is very high and horrific.
So effectively, you pay higher tax in case of debt MF (in the form of higher tax outgo – whether STCG or LTCG, and also in the form of DDT).

How taxes are calculated on SIP. Suppose I created a SIP for two year on equity MF. After two year I redeem total amount. Last SIP was invested for only 1 month and so on for other SIPs. Do I need to pay any taxes?

We’re doing a detailed post on SIP tax calculations which will be published on the 23rd. In SIP taxation, the rule that applies is that the first unit you bought is assumed to be the first unit you sold. Your holding period will be determined in this way. Then, based on the type of fund you hold, either short-term or long-term capital gains tax may apply.

The usual reason there’s a delay in publishing comments is because we usually try to reply to the comment before approving. That way, you would always get a reply to your feedback…and so we can keep track of which comments needs replying too! 🙂 So sometimes, it takes us a few days to do this, so there’s a gap between when you commented and the time we reply. Apologies for the delays in publishing your comments. We’ll try to be quicker from now!

A lot of you are asking for more clarity over how to look at these incomes and where they fall, as well as setting off. Therefore, we’ll do a separate blog on it in a couple of weeks. It will be easier to explain it in detail in a blogpost instead of in a comment. Do look out for it.

If you have short-term loss on equity and debt, you can set it off against short-term gains on equity and debt as well as long-term gains on debt. On a long-term loss in debt, you can set it off against long-term gain on debt. Long-term loss on equity can’t be set off against anything, as long-term gains are tax-exempt. We’ll cover all this in another blogpost, since quite a few of you have similar questions.

I am thinking of parking huge sum of money in debt mutual funds with yearly dividend payout option. All the websites showing returns on this funds are pre or post DDT? Reason this question came to me because if this is pre DDT then all the returns are less than prevailing current year FD returns except few expections in certain year like 2008 and 2011, and if this is post DDT then debt mutual fund dividend payout option make sense to me a little.

This sum will be parked for a very long term. In no circumstance i want to risk this capital that is the reason i am seeking this option but not getting proper information from anywhere?

When a debt fund declares dividend, the NAV falls to the extent of the dividend and the DDT. The dividend per unit that is shown is what you will receive in your hands. The DDT itself is taken out of the NAV. Your returns will thus be post-DDT. The ideal way in calculating returns while presenting dividend options is to assume that dividends are reinvested back into the fund (net of DDT, of course). Simply looking at NAV growth alone in dividend payout option will ignore the return that comes from the dividends. Debt funds will generally give you FD-plus returns because they invest in instruments that carry higher interest rates. An FD being a very safe instrument will give the lowest return. But interest is taxed at slab rates, so their post-tax returns will be even lower. Debt funds are more tax-efficient especially if held for more than three years. Hope its clear now.

Thanks for an excellent article and the clarifications.
I had a doubt, what if the person is not in any tax bracket, but has short term gains on sale of debt mutual funds? Since these short term gains are taxed at income tax slabs, is the person liable to pay tax or not? I am guessing there is another clause to make the person pay tax, but from the current rule it is not clear what that can be.

Thanks, Arun! Your tax depends on how much the gain is. If your income outside the capital gains is less than the taxable threshold (right now at 2.5 lakh), then your gain is reduced to that extent. So if the gain is completely accounted for by the extent to which your income is less than Rs 2.5 lakh, then you may not have to pay any tax. Use this link from the Income Tax website to compute your taxes: http://www.incometaxindia.gov.in/Pages/tools/income-tax-calculator-234ABC.aspx

Hi Bhavana,
Its still not clear to me. The return percentages for different types of debt funds that we see on different sites, are these returns calculated before or after deducting ddt? In other words, are these returns same in the hands of the investors who opted for dividend option?

Returns shown on websites are the returns of the fund’s portfolio. Those returns are a reflection of how the debt papers that the fund held did. A fund does not maintain a separate dividend plan portfolio and a growth plan portfolio. When websites or funds show returns, they are showing the performance of the fund, and not the plan. Very few websites show returns separately for dividend and growth; where they do, they assume reinvestment of dividend when they show the returns.

For you as an investor in the dividend plan, your own returns will be different because you are taking the dividend out at each point. You receive the dividend per unit as declared by the fund. The DDT on this is calculated separately. Both are deducted from your NAV. Opting for dividend payout simplly means that you are booking profit in your investment regularly. This reduces your investment in the fund which in turn reduces your return. You can read this post for a in-depth understanding of the differences between dividend and growth. https://blog.fundsindia.com/blog/mutual-funds/fundsindia-explains-why-the-growth-option-is-preferable/10425

I have invested in equity fund based MF, now i have sold the fund and realize that my last SIP was on 7/9/2015 and sale date is 31st Aug 2016. Do i need to pay short term gain on last SIP amount or it would be considered round of 1 year,.

DDT applies to corporates and retail investors, though the rate is higher at 34.6%. They have similar capital gains tax treatment as well, with whatever the applicable surcharge is. There’s no difference in treatment. For detailed tax queries such as yours, please talk your tax consultant. We deal with retail investors.

Dynamic bond funds are debt funds. Your dividend would have already had the tax component deducted by the AMC – you get the dividend post DDT. Since your holding period for all units is less than 3 years, you would have to pay tax on your gain (selling value minus cost value) at your slab rate which is 10%. Holding period rule defined by the tax law assumes the first-in-first-out rule – the units you bought first are the units you sold first. You can read our post on taxation of staggered investments here https://blog.fundsindia.com/blog/mutual-funds/fundsindia-explains-how-are-mutual-funds-taxed-part-ii/9153

If you made any redemption in your equity fund – whether partial redemption or fully – within 1 year of investing in it, you will have to pay short-term capital gains tax. Your gains will be calculated as the value of sale less the cost of the units you redeemed. That is, if you bought 100 units at Rs 10, and sold 50 units at Rs 20, your cost is Rs 500 (50 units * Rs 10), and your gain is Rs 500 (Rs 1000 – Rs 500). LPG refunds are taxable.

Hi could you please let me know the difference between ELSS and equity orientated funds

In ELSS we get tax savings and lockin period is 3 years
But as you mentioned Equity-oriented funds have no tax on long-term capital gains; i.e., if you sell your fund after 12 months from the date you bought it, you don’t pay capital gains tax.

All ELSS funds are equity-oriented funds – all ELSS funds invest in the stock market. The reason these funds are called ELSS and classified separately is because they have the Sec 80 C tax benefit and they are locked in for 3 years. All equity funds are not automatically ELSS and do not have lock-in periods. Because an ELSS fund is equity-oriented, capital gains are taxed like equity funds. So capital gain on holding period of more than one year is tax-free. Since ELSS is locked for 3 years, the gain you would make is also tax-free. Please read the post linked above to understand all this in detail.

I am a sr citizen. my interest income and annuity comes below 3000000/-.recently in 2016 I sold hdfc cash management fund and gained about 18500/-.(principal amount 200000/-) holding period is less than 3 years. how and where to show this amount in ITR1 form while submitting the retun?kindly advise.

If client is invested in growth option of debt /bond fund for more than 3 years (long term capital gains applies) and he wishes to switch from growth to dividend option in the same scheme, what is tax implication ? Does he have to stay invested for 3 years in dividend option of same scheme for long term capital gains?

If the investment period in the debt fund is longer than 3 years, then capital gains tax at 20% with indexation will apply. If there is a switch into the dividend option, there will still be capital gains to be paid on the switch. For the investment in the dividend option, calculation of the holding period for tax purposes will start on the date of the switch in.

The fund being referred to in that question was a debt fund. Debt funds have 3 year periods to qualify as long term; less than 3 years is short term capital gains. A switch from growth to dividend will attract long term or short term capital gains tax. Once the switch is done, holding period is again calculated from the date of switch in the new option.

Tax on a mutual fund applies at the time of redemption. The tax applies on the gains you make. Gains = Redemption value – Investment cost. In the case of SIPs, the law assumes that the first unit you bought is the first unit you sold. So based on the number of units redeemed, different dates can apply. If the date is more than one year before your sale date, then you will not have to pay capital gains tax. This article explains this with an example.

Hello,
As we’ve explained in the article, capital gains on holding debt funds for less than 3 years is taxable at your income tax slab rate. The tax is on the gain you make on a fund based on the holding period and whether it is an equity fund or not. Whether you hold a short-term fund debt fund or a long-term debt fund doesn’t matter. If you make capital gains on holding the fund for less than 3 years, it is short term and taxed. If you make capital gain on holding for more than 3 years, it is long term and taxed.

Under what section of Income Tax Act exemption of long term capital gains on equity MF funds is allowed?. Also please advise that if the income is exempted still we have to report the cap gain amount in the ITR ?

Taxation follows a first-in-first-out rule. That is, the assumption is that the first unit you bought is the first unit you sold. So in your case, whether you pay STCG on the redemption depends on the amount of the SWP and the number of units redeemed. If the units redeemed include those units got as dividend reinvestment, then you would have to pay tax. Please read this article to understand the rule I’m talking about.

I grand mother has 20 lacs fd on which she is getting interests ,this is her only source of income but now I moved with her and I am looking after her needs ,and want to invest this money in mutual funds in her name so should it be debt or equity . She never filed her return . So I am little confused on how move money from fixed deposit to mutual fund

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